December 1998, No. 98-8

Staggered Prices and Inventories: Production Smoothing Reconsidered

Staggered nominal price setting introduces predictable sales variations at the firm level. We study the implications of staggered prices in a framework where, because of increasing marginal cost, firms use inventories to smooth production and thereby separate sales from production. Conventional criticisms of production smoothing models have focused on their inability to replicate the following two stylized facts: (1) production is more volatile than sales and (2), inventory investment is positively correlated with sales. In contrast, we show that a standard production smoothing model of inventory behavior is consistent with these facts when prices are sticky. Moreover, these results hold irrespective of whether the economy is driven by nominal demand or real supply shocks. It has also been suggested that increasing short run marginal cost at the firm level can make the effects of nominal shocks more persistent. We show that if firms can hold inventories, nominal demand shocks will have persistent effects on sales, but not necessarily on production.